The two best-run big banks right now are Wells Fargo (NYSE:WFC) and U.S. Bancorp (NYSE:USB), but shareholders in even these companies must stay vigilant, as today's darlings are often tomorrow's pariahs.
"Wells Fargo and U.S. Bank look great now, but that stems, in large measure, from the fact that their business strategies during the economic downturn were relatively simple retail strategies (with minimal reliance on trading, investment banking income)," says Eric Fischer, senior fellow at Boston University Center for Finance, Law & Policy, and a former general counsel of UST Corp., a Boston-based bank holding company. "In my experience almost all 'heroes' tend to lose their luster over time."
To Fischer's point, history is replete with examples of respected financial institutions that were forced into insolvency seemingly overnight:
- The 1857 failure of the Ohio Life Insurance and Trust Company ignited the Panic of 1857. "The high credit enjoyed by that concern, and the fact that its solvency had hardly been questioned, made the failure a matter of [...] importance," the New York Herald reported at the time.
- The 1873 failure of Jay Cooke & Co., the most highly reputed investment bank during and after the Civil War, triggered the Panic of 1873 and subsequent economic depression.
- The failure of the once-esteemed Knickerbocker Trust Co. set off the Panic of 1907.
And the list goes on, as Fischer himself witnessed:
When I joined Bank of Boston in 1976, the large bank model, which the 50 largest banks tried to emulate, was Continental Illinois in Chicago, [the seventh largest bank in the United States at the time]. Only a few years later, Continental Illinois had to be rescued by the FDIC with emergency funding being provided by the other 25 largest banks (including Bank of Boston, i.e., The First National Bank of Boston).
Banking is risky by nature. For every $1 in capital, the typical bank borrows $10 or more in debt. It then uses the combined proceeds to underwrite loans and invest in fixed-income securities, such as Treasury bonds and mortgage-backed securities. The spread between what a bank pays to borrow money and what it receives in interest from reinvesting the funds accounts for the majority of revenue at most banks across the country.
This is a profitable business model when the economy is healthy and loan defaults are few and far between, but it's unforgiving when things take a turn for the worse. In the financial crisis of 2008-09, for instance, Lehman Brothers was leveraged by a factor of 30 to 1. The only thing standing between it and complete insolvency was a 3% decline in the value of its assets. We all know how that turned out.
These same forces have caused thousands of bank failures over the past two centuries. In the 215 years since the turn of the 18th century, as I've noted before, the United States has experienced 14 major bank panics. That equates to one every decade and a half. Each time this happens, legions of institutions fail because of imprudent lending in happier times. More than 17,000 banks have failed in the century and a half since the Civil War, equating to an annual average of 115.
Despite this, it's important to give credit where credit is due. And, at least in the cases of Wells Fargo and U.S. Bancorp, there's reason to believe both are positioned to outperform the bank industry for years to come. This follows from the fact that U.S. Bancorp and Wells Fargo have long been the two most efficient big banks in the country. By keeping their costs low, they're able to underprice competitors for the best borrowers while still generating a respectable rate of return for shareholders.
This playbook has worked for time immemorial, both inside and outside the bank industry. The great steamboat and railroad tycoon of the Gilded Age, Cornelius Vanderbilt, offers a case in point. He built a steamboat empire by focusing excessively on expenses. He shifted costs to customers, chose his routes wisely, and designed his steamships so they required less coal to operate. Vanderbilt later did the same thing in the railroad industry.
As T.J. Stiles explains in The First Tycoon: The Epic Life of Cornelius Vanderbilt:
Vanderbilt's most famous reform [after purchasing the Harlem and Hudson River railroads] was the most superficial: he forbade brass ornamentation on all locomotives, to save the time spent polishing them. This one step attracted lengthy comment in newspapers and railroad journals. Clearly it sent a powerful signal that economy would be Vanderbilt's defining principle.
The benefit from this approach in the short run is obvious, but it's equally significant over the long run. In the short run, the fact that Wells Fargo and U.S. Bancorp spend a smaller share of net revenue on operating expenses means that more money falls to the bottom line, which can then be distributed to shareholders or retained to boost book value. Over the long run, meanwhile, because these banks can afford to attract the best borrowers with lower interest rates, they tend to lose less money when an economic downturn causes default rates to soar. It's a powerful one-two punch that gives these banks an almost insurmountable competitive advantage.
Thus, the biggest threat to banks like U.S. Bancorp and Wells Fargo are unforced errors. These can happen, as we've seen many times in the past, to one-time industry darlings, but it seems unlikely so long as the banks adhere to their current cultures of thrift and prudence.
John Maxfield has no position in any stocks mentioned. The Motley Fool owns and recommends Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.